The IMF warning reveals just how extreme George Osborne's austerity is

A radically different approach is needed if even the gung-ho enforcer of fiscal discipline is telling the chancellor to slow down

During Argentina's 2001 financial crisis it stuck to the IMF programme, handing over 'trickles of cash in exchange for deeper austerity', resulting in poverty and social unrest. Photograph: Fabian Gredillas/EPA

It is only a few months ago that the chancellor, George Osborne, was preening himself on the International Monetary Fund's clean bill of health for the UK. The IMF's inspectors had given his slash-and-burn economics their seal of approval.

How times change. The IMF has revised its growth forecasts for UK downwards three times in 2011, from 2% at the start of the year to 1.1% on Tuesday. It has, in an exceptional move, warned of the consequences of too great a rush to cut.

The IMF was a peculiar international midwife for a new style of economic management that came to be known as "neoliberalism". Public spending was to be cut. Financial markets would be liberated. The state itself would be rolled back, making room for entrepreneurs. A harsher but more dynamic world would result.

But it wasn't supposed to be like this. Founded at the Bretton Woods conference in 1944, the fund arrived in a burst of optimism. The breakdown of international co-operation and economic disintegration of the 1930s could never be repeated. Confidence in the power of governments to control and manage markets had never been higher. The IMF was intended only as the quiet defender of a new regime of fixed-interest rates as part of this new world. These fixed rates would in turn support governments committed to the domestic management of their own economies. The IMF's cash reserves, provided by member states in proportion to the size of their economies, would be used to make emergency loans for countries facing currency difficulties.

That was the theory. In practice, voting rights in the IMF were dependent on the size of subscription fees, handing an automatic majority to the bigger economies. The "Bretton Woods regime" rested implicitly on a strong dollar. As this came under growing pressure throughout the 1960s, the system of fixed exchange rates broke down. Richard Nixon abandoned the dollar peg to gold in 1971, leaving the IMF essentially bereft of a role.

So the fund reinvented itself. From docile guardian of international monetary stability it became the gung-ho enforcer of domestic fiscal discipline. There is no convincing connection between the two roles. The period in which the prescriptions of neoliberalism came to dominate is punctuated by successive financial crises, culminating in the spectacular global collapse of September 2008.

Yet the absence of obvious success has done little to diminish the IMF's overweening enthusiasm for intervention. Quite the opposite. Time after time, it has bloody-mindedly stuck to its principles.

One-time IMF poster-boy Argentina stuck rigidly to the prescription throughout the 1990s. Keep the currency credible by pegging it to the dollar. Keep spending down. And keep making the loan repayments. With continued IMF loans, Carlos Menem's government appeared to be delivering the goods. A preceding decade of hyperinflation and near-bankruptcy had been seemingly turned around. By early 1997, Michael Camdessus, the then IMF director, was lavishing praise on Argentina's "magnificent performance". He was "very confident" about its future.

This was, predictably, just prior to the debacle. Argentina's success had little to do with the IMF's prescriptions, and much to do with brute luck. Low US interest rates helped keep the dollar-pegged peso from appreciating, while a US recovery from the early 1990s onwards boosted Latin America generally.

Ripples from the east Asian crisis in 1997 exposed its weakness. As the dollar appreciated, Argentine terms of trade slumped. A recession set in. And as recession bit, Argentina's ability to make debt payments dwindled.

The IMF response was to insist on the orthodoxy. Cuts in government spending would pay for the debt. But cuts dragged the economy down still further. As recession turned to slump, the IMF set its face. By early 2001, Argentina was barred from international capital markets. The IMF was its only remaining lender. Impervious to rising social unrest, it handed over trickles of cash in exchange for deeper austerity.

The denouement arrived at the end of the year. The then president, Fernando de la Rúa, fled the blazing streets of Buenos Aires in traditional style – by helicopter, from the roof of the presidential palace. A new administration defaulted on its $132bn debt on 31 December 2001, and abandoned the currency peg weeks later. Argentina had broken all the rules of the game.

The immediate shock was substantial. Economic activity ground to a near-standstill. But as the dust settled, contrary to predictions, the economy boomed – by up to 8% a year. Argentina is currently the fastest-growing economy in South America.

The story can be repeated. Those countries in east Asia that stuck to IMF prescriptions in the midst of their crisis suffered abysmally. Those that chose to breach IMF rules, clamping down on capital markets, fared better. Ecuador and Bolivia have had similar experiences.

Under significant pressure, the fund has in recent years displayed flashes of social conscience. The severity of the current crisis has provoked grudging acknowledgment. It remains, however, committed to its own neoliberal vision of the world. That even the IMF now criticises Osborne should indicate the extremity of his programme. A radically different approach is needed.